The Cost of Foreign Exchange Intervention Can Reserve … · around the world Trend Figure:Reserves as a Share of GDP (%) 0 10 20 30 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

The Cost of Foreign Exchange InterventionCan Reserve Accumulation be Counterproductive?

UNCTAD Summer SchoolGeneva, Switzerland

Devika Dutt

University of Massachusetts [email protected]

September 4, 2018

Devika Dutt (UMass Amherst) Counterproductive Reserve Accumulation? September 4, 2018 1 / 20

Overview

1 MotivationTrend in Reserve AccumulationReasons for Reserve Accumulation

2 Research Question

3 Basic Assumptions and Stylized Facts

4 Model

5 Conclusions

Extent of Foreign Exchange Intervention

Central Banks intervene regularlyon the foreign exchange market,typically through sterilized sale andpurchase of international reserves.

There has been an unprecedentedincrease in accumulation of foreignexchange reserves in central banksaround the world

This accumulation has alsocoincided with increasedliberalization of the capital accountaround the world Trend

Figure: Reserves as a Share of GDP (%)

010

2030

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015year

Developing Countries Emerging CountriesDeveloping Countries excluding China Advanced Countries

Foreign Reserves (excluding gold) as a share of GDP

Source: Author’s Calculations based data fromWorld Bank World Development Indicators

010

2030

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015year

010

2030

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015year

010

2030

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015year

010

2030

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015year

Figure: Reserves in Months of Import

05

1015

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015year

Foreign Reserves (excluding gold) in months of imports

Source: Author’s Calculations based data from World Bank World Development Indicators

Why is this being observed?

Reserve holdings allow central banks to lean against the trilemma orwiden the policy space constrained by the trilemma

A rise in reserve holdings often lowers the cost of private debt andequity capital (Feldstein, 1999)

To some extent, reserve holdings have substituted for capital controls(Ilzetzki et al., 2017)

Holding of international reserves equal to at least the value of shortterm external debt reduces the annual probability of a countryexperiencing a share reversal in capital flows, which can precipitateand external debt and/or currency crisis, by 10 percentage points(Rodrik, 2006)

Reserves of foreign exchange are built to provide insurance againstspeculative currency attacks

But what is the Cost of this Self-Insurance?

Direct Quasi-Fiscal Cost Associated With Foreign ExchangeIntervention

Indirect Cost of Foreign Exchange Intervention

Political Cost Associated with Mitigating the Cost of ForeignExchange Intervention

But what is the Cost of this Self-Insurance?

Direct Quasi-Fiscal Cost Associated With Foreign ExchangeIntervention

Indirect Cost of Foreign Exchange Intervention

Political Cost Associated with Mitigating the Cost of ForeignExchange Intervention

Research Question

Main Purpose: To theorize and identify potential indirect costs offoreign exchange intervention.

Research Question: One of the best predictors of financial crises canbe shown to be excessive credit growth. In particular, gross flows ofcapital can serve as a source of significant instability, even if net flowsdo not reflect an imbalance in the balance of payments. Is it possible,then, that higher reserve holdings encourage higher capital inflowsand create instability and crisis, ceterus paribus?

Contribution:

There is very limited literature that studies this question, and the fewstudies that study it focus on micro-level risk taking.A Minksyian model that incorporates stylized facts of balance ofpayments/ financial crises.A cross-country empirical investigation of this phenomenon based onmy model.

Research Question

Main Purpose: To theorize and identify potential indirect costs offoreign exchange intervention.

Research Question: One of the best predictors of financial crises canbe shown to be excessive credit growth. In particular, gross flows ofcapital can serve as a source of significant instability, even if net flowsdo not reflect an imbalance in the balance of payments. Is it possible,then, that higher reserve holdings encourage higher capital inflowsand create instability and crisis, ceterus paribus?

Contribution:

There is very limited literature that studies this question, and the fewstudies that study it focus on micro-level risk taking.A Minksyian model that incorporates stylized facts of balance ofpayments/ financial crises.A cross-country empirical investigation of this phenomenon based onmy model.

Basic Assumptions

Global financial cycle in in capital flows, asset prices, and creditgrowth that is correlated with monetary policy in the core countries,regardless of specific domestic macroeconomic conditions.

International monetary system in which a national currency, the USdollar, is the reserve currency.

One of the best predictors of financial crisis is excess credit growthand or gross capital inflows.

Basic Assumptions

Reserve Accumulation and Crises

Figure: Reserve Accumulation and Crises in Emerging Markets0

5010

0To

tal r

eser

ves

(% o

f GD

P)

1960 1970 1980 1990 2000 2010 2020Year

Algeria

05

1015

20To

tal r

eser

ves

(% o

f GD

P)

1960 1970 1980 1990 2000 2010 2020Year

Argentina

05

1015

20To

tal r

eser

ves

(% o

f GD

P)

1960 1970 1980 1990 2000 2010 2020Year

Colombia

05

1015

Tota

l res

erve

s (%

of G

DP)

1960 1970 1980 1990 2000 2010 2020Year

Costa Rica

Figure: Reserve Accumulation and Crises in Emerging Markets0

510

1520

Tota

l res

erve

s (%

of G

DP)

1960 1970 1980 1990 2000 2010 2020Year

Sri Lanka

05

1015

Tota

l res

erve

s (%

of G

DP)

1960 1970 1980 1990 2000 2010 2020Year

Turkey

510

1520

2530

Tota

l res

erve

s (%

of G

DP)

1960 1970 1980 1990 2000 2010 2020Year

Uruguay

24

68

1012

Tota

l res

erve

s (%

of G

DP)

1960 1970 1980 1990 2000 2010 2020Year

Zimbabwe

Figure: Reserve Accumulation and Crises in Advanced Economies0

200

400

600

Tota

l res

erve

s (%

of G

DP)

1960 1970 1980 1990 2000 2010 2020Year

Greece

2040

6080

Tota

l res

erve

s (%

of G

DP)

1960 1970 1980 1990 2000 2010 2020Year

Italy

24

68

1012

Tota

l res

erve

s (%

of G

DP)

1960 1970 1980 1990 2000 2010 2020Year

New Zealand

200

400

600

8001

0001

200

Tota

l res

erve

s (%

of G

DP)

1960 1970 1980 1990 2000 2010 2020Year

Portugal

Basic Schematic of my Model

Moral Hazard Problem

...no ex-ante announcement by policymakers can convince the public that

ex-post (that in the midst of a generalizedfinancial turmoil) the government would

cross its arms and let the financial systemproceed towards its debacle.

(Corsetti et al., 1999)

Basic Dynamics: Total Lending

Conclusions

The International Monetary System has moved to a configuration inwhich central banks are increasingly accumulation reserves throughforeign exchange intervention.

Reserve accumulation could theoretically create conditions of moralhazard that allows attracts increased gross flows into the economy,and thereby could create increased financial instability.

This is not to suggest that countries should not accumulate reserves:they provide a very important buffer against the effects of volatilegross capital flows.

Some of these effects can be mitigated by other policy tools tomanage the external account, like capital controls or policycoordination.

Conclusions